Are commodity merchants "swap dealers" by any other name?

Chris Baltimore

10 Min Read

HOUSTON (Reuters) - Big energy companies like Royal Dutch Shell and commodity merchants like Cargill have a simple argument in pushing back against looming new swap market rules: We’re not a bank, so don’t regulate us like one.

But their efforts to avoid being branded a “swap dealer,” a designation that brings with it greater scrutiny and onerous new rules, tend to sidestep the fact that, in one small but important way, most of them trade exactly like a bank.

For much of the past decade, companies including BP Plc, U.S. conglomerate Koch and Swiss-based trader Vitol have quietly offered their hedging strategies and risk management savvy to other firms, often going head to head with banks like Goldman Sachs and Morgan Stanley to pitch airlines, utilities or producers on ways to hedge prices.

Now, a pivotal rule in the financial overhaul of the $700 trillion derivatives market may force them into a stark choice: retain their third-party swap-dealing desks and shoulder the mantle of extra regulation; or cede the hard-won and potentially lucrative prize back to the big banks.

The Commodity Futures Trading Commission (CFTC) on Tuesday once again delayed a high-stakes vote on definitions for “major swap participant” and “swap dealer,” designations that will determine which companies will face heightened regulations. The CFTC gave no reason for removing the rules from the agenda of its planned February 23 meeting.

It is the latest in a series of delays on these controversial definitions that the CFTC is jointly working on with the Securities and Exchange Commission.

Commodity companies argue that although they may trade billions of dollars a year in swaps, they should be spared the CFTC regulations because they use the market principally to shield themselves from risks associated with the physical assets they own — be it an oil well, refinery, or power plant.

While few dispute that the bulk of such trades are made on behalf of the company’s own risks, these firms are also a visible presence in the world of third-party sales, said Chris Thorpe, executive director of energy derivatives at INTL FC Stone, a broker that also offers risk management services.

“For the bigger, more credit-intensive customers we pitch to, we’ll see these guys as competitors about 25 to 50 percent of the time,” Thorpe said.

Dodd-Frank requires swaps dealers and large participants to trade swaps on exchanges or platforms known as swap execution facilities, and use clearinghouses that guarantee the trades to lower risk. It will also require swaps dealer to post significant cash collateral against default risk.

Much will depend on how and where the CFTC draws the line on what separates a “dealer” from a “major participant”. So far, the CFTC has said it expected as many as 40 non-bank firms to be required to register as swap dealers. End-users would be exempted from some of the regulations.

Last week, the Financial Times reported that the agency would increase the threshold for defining a swap dealer to $2 billion worth of swaps sold per year, up from $100 million initially proposed. But even that new ceiling may still capture most of the larger players in the space.

BP reported the fair value of its derivatives holdings at $7.2 billion at the end of 2010, one-fifth as much as Goldman Sachs. But three-quarters of BP’s total was in natural gas.

“WE WILL HAVE TO PAY THEIR PRICES”

Companies like Shell, BP and Vitol say the Dodd-Frank reforms were never intended to saddle commercial firms who are managing their own risk.

“We’re not swap dealers. We don’t take either side of any transaction,” said Mark Menezes, a partner with Hunton & Williams LLP in Washington, the law firm that serves as counsel to a group of energy companies that is lobbying the CFTC to change the rules. “One shouldn’t be deemed to be a swap dealer if swaps are used to mitigate commercial risk.”

They warn that a wide-sweeping definition that captures these merchants could very well be a boon to financial players who could exert more pricing power — to the detriment of corporations who are already facing higher regulatory costs.

“This action would needlessly increase the cost of hedging and reduce the capital available for capital investments and job creation by our members,” trade groups including the American Gas Association and the Edison Electric Institute wrote in a February 14 letter to White House officials.

Others dismiss such claims as spurious and say that banks and industry players should face equal regulation for equal opportunity.

“If Shell is dealing in derivatives in direct competition with Goldman Sachs, they shouldn’t be held to a different standard than Goldman Sachs,” said John Parsons, a professor at the Massachusetts Institute of Technology who is an expert on energy policy and corporate risk management.

Energy merchants can be fierce competitors too, often offering greater flexibility in making or taking delivery of the physical commodity, or advantageous credit terms, bank sources say.

Shell, BP, Vitol and Koch all declined to comment on the significance of their risk operations for this story. Two industry sources said BP was one of the biggest natural gas swap traders in the business, but none of the companies provide any data on the size or scale of their market-making operations.

Even a cursory search on their websites yields only a brief mention of their services, such as the following for Shell: “Shell Trading (US) Company can deliver a market-smart edge to your price risk management program.”

But if merchant players opt to take on the regulatory burden, it could intensify competition with banks like JPMorgan Chase & Co., Barclays PLC and others that are working hard to maintain their billion-dollar commodities franchises and retain traders at a time of growing regulations, volatile markets and diminished bonuses.

ARE YOU IN OR OUT?

Key to many companies’ future trading strategy will be how broadly the CFTC defines “swap dealer,” especially the de minimis exemption that is meant to shield commercial end-users from the regulations. Prior to the FT report, a potential limit of $1 billion in swap trades was still seen as too low.

“A billion dollars is not nearly enough,” said Brenda Boultwood, chief risk officer and senior vice president at Constellation Energy, a firm that trades large volumes of swaps but does limited hedging on behalf of third parties.

“It’s barely enough to hedge a single power plant. Most energy companies would be captured under this definition as it’s rumored to be written.”

Once the rules are made, every market player will have to decide whether the extra cost of regulation — more compliance officers, more back-office support staff, rejiggered computer trading software — will be worth the profits gained.

Those costs are not trivial. A study by National Economic Research Associates Inc commissioned by the Working Group of Commercial Energy Firms found that it could cost $388 million for 26 non-financial energy companies to comply with the rules — including $153 million in margin costs, $204 million in capital costs and $31 million in business compliance costs.

“It may not impact their ability to engage in certain transactions that fall within the definition of swap dealer,” said Michael Sweeney, a lawyer with Sutherland Asbill & Brennan LLP in Washington who also represents energy companies who are directly lobbying the CFTC on the Dodd-Frank rules. “However, it will very likely impact their willingness to offer them.”

Beyond the real costs, many say these commodity merchants may be loath to take on the burden of more intense federal regulation — something banks have lived with for decades.

“A lot of the energy companies just don’t have that infrastructure in place, nor do they have an organizational structure or the same history of being regulated,” says Paul Campbell, head of Deloitte & Touche LLP’s energy trading and risk management practice.

THE SINS OF OTHERS

At a minimum most expect smaller players to exit swap-dealing entirely rather than build out the new layer of compliance officers and trade-tracking programs required by the CFTC. After all, for most of them the profit from market-making is small relative to the revenues from producing oil or grains.

Views are mixed about which way they will go.

While merchants may fight tooth and nail to avoid being dubbed swap dealers, the executive had little doubt: “They have people showing up at all the same forums. They’re all preparing to comply with this regulation.”

Another executive at a different Wall Street bank was blunt: “We think they’ll get out of the business.”

Vincent Kaminski, a professor at the Jones Graduate School of Business at Rice University in Houston and a former Enron Corp quantitative analyst, says he wouldn’t be surprised to see some of Houston’s big firms lay off traders.

All the while, commodity industry executives will remind anyone who listens that it wasn’t energy or grain swaps that nearly brought down the financial system in 2008.

“Talk to any energy trader and they say they didn’t cause this but they are now paying for the sins of others,” says Kaminski.

Additional reporting by Jonathan Leff in New York and David Sheppard in Palm Beach, Florida; Editing by Lisa Shumaker